India’s surging share valuations enter a demanding zone
In the long term, share prices become a function of what they inherently represent—the value of a business. Conventional valuation parameters, grounded in fundamentals such as earnings, indicate that valuations have moved to a higher trajectory. This either means that Indian companies are poised to deliver superior earnings growth or there is overvaluation.
On 14 December, at its closing value of 70,514 points, the S&P BSE Sensex was valued 24.8 times the earnings of its 30 constituents. This average monthly price-to-earnings (PE) ratio of the Sensex has been higher than this only about 20% of the time since 1990.
While it has delivered gains even at higher valuations, some of the corrections have been brutal—the Harshad Mehta securities scam in 1992, the dotcom crash in 2000, and the US financial contagion in 2008.
Unlike those phases, this Indian market is not a dire one. But it’s pulling away from both its own long-term averages and from other markets, raising levels of downside risk.
Among 45 markets tracked by World PE Ratio, a financial information website, India is the third-most richly valued, after Nigeria and New Zealand, both minor markets. Of these 45 markets, 16 trade above their 20-year PE average, led by New Zealand, India, Taiwan, and the US.
Deviating from average
The 20-year PE average of the Sensex is 16.8. In other words, it is currently about 40% above its 20-year average. The PE ratio is relative, reducing with earnings growth. Theoretically, a 25% growth in earnings of the 30 Sensex companies will pare this ratio from 24.8 to 19.8, where it starts to look more reasonable. A 15% growth in earnings will lower it to 21.6.
The Sensex is less of a concern, as it comprises the finest of India Inc, and their long-term prospects remain good. Of greater concern are indices that represent the lower reaches of the stock market.
Some have run up significantly more than the Sensex in 2023, and their constituents are less known, some even might be flavours of the season. The S&P BSE IPO index, for instance, has surged 43% and is trading at a PE of 47. Can companies in that set grow their earnings 50-100%?
All about earnings
Earnings in the past three years have been affected by the Covid-19 pandemic. So, in some quarterly periods, there’s a base effect to account for. Since the quarter to September 2022, the covid effect has been contained.
In the five quarters beginning September 2022, year-on-year growth in combined net profit for the 30 Sensex companies has ranged from 5% to 28%. Revenue growth on a y-o-y basis has been a lot more stable, ranging from 15% to 22%.
When the market assigns a PE of 24.8 to the Sensex, the best-case scenario is an expectation that corporate earnings will grow at a fast clip—25-30% a year. If that doesn’t materialize, corrections could follow.
Corrections can especially hurt if any admittance of overstated fundamentals overlaps with a weakening in investor sentiment and a drying of money taps, which are currently brimming with eager foreign and retail funds wanting to ride the momentum.
Rich market
Another metric used to assess markets for richness of valuations is the market capitalization-to-GDP ratio. Crudely put, this is the price-to-sales ratio for an entire country. Over the years, the reading of this ratio has been that a figure below 50% makes a market undervalued and a figure above 100% makes it overvalued.
On an average annual basis, the Indian market, as represented by all stocks on the National Stock Exchange, crossed a market cap-to-GDP ratio of 100% for the first time in 2020-21. It is now 111% on estimated 2023-24 GDP, an all-time high.
One reason is the slew of new listings, leading to an inorganic expansion of the market cap. Still, this is cautious territory. At these valuations, greater demands will be placed on earnings growth, both in terms of how much and how soon. Disappointments on both fronts could hurt.
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